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Accumulations of Income

Late one night I sat down to read the notes produced by the Inland Revenue (as one does!) on how to fill in the Trust and Estate tax Return.

When turning to question 13, which deals with the tax treatment of discretionary payments of income made to beneficiaries, I noticed that the Revenue consider that ` …. payments out of capital or accumulated income are not to be regarded as the income of a beneficiary irrespective of the purposes for which they are made ….`

Whilst this statement is innocent enough by itself, the question it raises is simply at what point in time does retained income lose the quality of income and become capitalised? For example, will income retained on income account retain the quality of income indefinitely? Or will the effect of investing income in suitable investments have the effect of capitalising that income?

These questions become particularly relevant when looking to make tax efficient payments from a trust by taking advantage of the tax pool. If, for example, one takes an accumulation and maintenance trust (whether subject to the provisions of s.31 Trustee Act 1925 or not) and seeks to make an `income payment` to a beneficiary immediately before he takes a vested interest (whether in possession or absolute) is it correct to say that such a payment can be treated as income in the beneficiary’s hands for taxation purposes? And, if so, can the tax pool can be `cleared out` immediately before that beneficiary’s interest becomes vested? If retained income effectively loses that quality and becomes capitalised, the corollary is simply that the payment of retained income cannot be treated as the beneficiary’s income and the tax pool effectively becomes stranded.

After correspondence with FICO Trusts and Settlements on this subject the following view emerged, which you may find interesting.

Essentially, when dealing with trust income in which no initial beneficial interest can be said to subsist, FICO considers that there are three possible types of case. It is therefore necessary to determine which case applies to retained trust income in order to determine whether it can be distributed as income for income tax purposes. This article looks at each of these cases in turn

Cases where there is a duty to distribute income which is not coupled with a power to accumulate it.

Examples of this type of case are:

Re Gourju [1942] ALL ER 605 and

Re Locker [1977] 1 WLR 1323

Cases of this kind would typically require the trustees to distribute income but give them discretion as to which beneficiaries should receive it.

In Gourju it was decided that where there was a duty to distribute trust income the trustees obligation was `to apply the income as and when they receive it …. with of course such necessary limitations on absolute obligation as the practical necessities of the case demand`. The Gourju decision was accepted in Locker where it was also held that discretion of the trustees arising under an obligatory power ought to be exercised promptly in every case.

In this type of case retained income will always retain its identity and willalways be ultimately distributed by the trustees’ discretion over income.

Cases where there is a power to distribute coupled with an in-default trust (including s.31 Trustee Act 1925 trusts)

In this type of case the trustees have a permissive power to distribute income as opposed to an obligatory power (as illustrated in 1 above). The decisions in bothAllen-Meyrick and Gulbenkian hold that once a reasonable period of time elapses the discretion is no longer exercisable and the default trust comes into operation.

Moreover, there is nothing in either of these cases to support the proposition that the settlement trustees are entitled to take a conscious decision to retain income and thereby postpone indefinitely the activation of the default trust.

Cases where there is a power to accumulate coupled with an in-default trust

An example of this type of case is:

Pearson v CIR [1980] STC 318

In this type of case the trustees have a permissive power to accumulate income. In Pearson, the judgements of Viscount Dilhorne and Lord Keith (with which Lord Lane concurred) refer to the fact that the default trust did not come into operation (and therefore provide the beneficiary with an interest in possession) until the trustees had had a reasonable time in which to come to a decision not to accumulate. This approach seems wholly consistent with the type of case in 2 above.

What is meant by a reasonable time?

Where there is a permissive power followed by a default trust it is unofficially considered by the Revenue that subject to any special circumstances, 5 to 6 months from the date income arises is ample time for the trustees to make up their minds whether or not to exercise the permissive power. The power will then lapse and there will be an automatic accumulation of income. For my part, I consider that a longer period, such as one year should be permissible.

Income retained in income account and power to pay income as income of the then current year

It should also be noted that the retention of trust income in income account after the permissive power has lapsed and, in the Revenue’s eyes therefore, the automatic accumulation of that income will not permit the trustees to apply accumulations `as if they were then income arising in the then current year` for income tax purposes, either under s.31(2) Trustee Act 1925 or under a special power conferred in the trust instrument itself. The Revenue apparently has two Special Commissioners decisions from the 1970s, which held that the exercise of such a power did not have the effect of making the payments income in the hands of the beneficiary. The ratio of the decisions was that accumulation involved capitalisation of the income and the subsequent use of the power did not have the effect of de-capitalising the accumulated income.

In conclusion, the Revenue considers that there may be a difference between the trustees treatment of funds as `income` and the legal position that accumulated income loses its character as income for tax purposes. Having said this however, it should be borne in mind that the Revenue will generally follow whatever decision the trustees take, unless such a decision seems perverse by reference to the known facts.